imaginima/E+ via Getty Images

imaginima/E+ via Getty Images

A lot has been said about Transocean Ltd.'s (NYSE:RIG ) debt load and the fact the company's backlog is not increasing. However, this is already more than factored in the share price, especially given the considerable short interest in the stock. The offshore drilling sector is recovering gradually. The process might not be as quick as many investors want it to be. But since there is an energy crisis around the world and the supply chains may take months and even years to rebuild, the oil prices will remain high, which is a great positive for RIG's day rates.

My colleague Henrik Alex wrote a detailed article covering the company's first-quarter earnings results. But in this article I would like to focus on the industry's long-term trends and macroeconomic factors mentioned in the management's presentation.

Europe is going through an energy crisis due to the situation around Ukraine. The sanctions imposed did not just limit natural gas supplies but also oil due to the financial restrictions. In that situation, EU desperately needs to find alternative sources of these commodities. Equinor (EQNR) is the most obvious choice. A significant part of its operation is located in the North Sea. However, in spite of this evident demand, Norway is facing difficulties involving the necessary subsea equipment supplies. But Transocean's CEO expects the North Sea market to be fully sold out by 2024, which is also a sign of strong demand.

Nowadays, however, great opportunities for RIG have emerged in many regions. The most attractive ones are West Africa and Brazil. I was particularly pleased to hear that the management see 20 opportunities in West Africa and predict a minimum of 15 rig years could be awarded. Brazil also seems to be an interesting market - this year 5 rigs have already been booked. With the new tenders that are out Transocean's management expect additional 16 rigs to get occupied in the remainder of 2022.

The Development Driller III secured an 80-day contract with Brazilian Petrobras (PBR) at a dayrate of $331,000. This is a pretty good rate. But in the Gulf of Mexico, the Deepwater Invictus secured a 2-well extension with BHP Billiton (BHP) at a rate of $375,000 per day. This makes the Gulf of Mexico seem like a particularly good opportunity especially now when shale oil producers are unable to drastically raise their production levels.

However, as I have mentioned before in my other article, developing regions seem to be more reliable for Transocean, given their more lenient environmental regulations. However, since we are facing an energy crisis, both the EU and the US governments may be supportive of additional oil drilling.

When I first wrote about Transocean, my fellow Seeking Alpha contributors and some readers argued onshore drilling was more attractive for oil giants as opposed to offshore. True, onshore drilling does not require as many initial investments and is therefore more flexible. That is, it is theoretically easy to both increase and decrease production. However, I am sure many investors have been wondering for a while why American shale producers are not raising their output. The situation is more than favorable. Most coronavirus-related restrictions are over in many countries, there is an energy crisis and oil is trading for more than $100 per barrel. If onshore drilling is so flexible and cheap, why then would shale giants not dramatically raise their production? Doing so would sharply raise their revenues, it seems.

The situation is not as easy as it looks like. Shale oil producers in the US suffer from a lack of high-quality acreage, poor logistics, lack of human resources and quite a history of chronic underinvestment in oil field development. Some constraints include a clear shortage of drilled but uncompleted wells, drilling equipment and even necessary materials. For example, cobalt is heavily demanded by the industry but due to the situation in Ukraine there is a lack of cobalt supplies, which is impacting the oil industry. What is more, during the 2020 oil price crash many oil workers lost their jobs. Some of them obviously returned to their workplaces but some decided to change occupation. This explains why the US oil industry is also dealing with staff shortages. What is more, the ESG agenda made many bankers and investment funds evade oil and gas businesses and instead direct their funds to alternative "green" energy companies. This situation may take years to resolve and it seems the market may be undersupplied, which is highly bullish for the oil prices.

Although many oil companies are rather focused on paying their stockholders dividends and buying back their own shares, it now makes sense for oil majors to invest in new wells wherever they can, including offshore drilling, and not just onshore. It is obvious that some onshore oil does not cost much to drill. For example, in Saudi Arabia the break-even cost of extracting such oil is around $10 per barrel. But not onshore oil is that cost-efficient to extract.

The break-even costs of offshore, as the management mentioned during the call, are in 80% of projects below $60 per barrel and in many cases below $40. Obviously, if the oil prices stay near $100 per barrel, companies can make a great deal of profit. New offshore wells are also quite economic to drill since they can be used for 30 years, which is clearly not the case with onshore oil. That is why long-term offshore projects can make perfect economic sense if the prices for the base commodity stay at the current level.

Many analysts are worried the Fed's tightening might lead to recession. That is well possible and could be a downside for the oil market. However, in the 1970s there were several recessions and the prices for black gold were really high.

Please see the graph with the history of inflation-adjusted oil prices below. The recession periods are marked in grey.

In fact, high inflation was partly due to high energy prices and provoked the Fed to raise the interest rates. This, in turn, led to recessions and stagflation - high unemployment and high inflation. The situation may repeat itself now.

In my view, RIG's shares are undervalued. There is a sizable short interest in the stock. Most traders ignore it because of the company's debt load. But the management proved their competence in 2020 when they restructured their debt without making their company go through the bankruptcy procedure.

A good EV-to-EBITDA ratio is typically around 10 or below. S&P 500's average EV-to-EBITDA is typically between 11 and 16. Transocean fulfills this criterion since its ratio is around 10. If we see the history of RIG's EV-to-EBITDA, we will see that at times it was much higher than it is now. That's why Transocean's stock is not overvalued right now by this measure.

This reasonable valuation and even undervaluation is also the case with RIG's price-to-sales (P/S) ratio. After the oil price collapse in 2020, the P/S lingered below 0.30. It was extremely low, of course. Now it is significantly higher, near 1 but way below the 2018 indicator of 2.

So, right now the stock is not overvalued.

I perfectly understand some analysts consider Transocean to be a high-risk stock. But let us not forget that it is also a high-return stock. It is quite undervalued, whereas the offshore recovery is starting to take place. I particularly favor the Gulf of Mexico due to its high day rates but West Africa and Brazil also seem to be attractive. The only downside risk is that of a likely recession. But even if it takes place, we might end up in a situation of the 1970s when oil prices were high in spite of stagflation. RIG is a definite buy to me.

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Disclosure: I/we have a beneficial long position in the shares of RIG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.